Inflation targeting: time for a change?

When Mark Carney arrived at the start of this month to speak to the treasury committee, it was a chance for him to lay out his vision for the Bank of England when he takes charge, with many expecting wholesale changes. Yet, Britain’s MPC has had a relatively quiet time of late – interest rates have been static for almost 3 years and inflation has remained at 2.7% for the 4th month in a row. However, such a settled picture should not stop a reevaluation of the Bank of England’s strategy. It is already expected that the incoming governor will oversee the burgeoning much-ballyhooed reform of Britain’s banking system, but there could be scope to consider the very way that the Bank targets inflation, the central core of its powers.

Many have attempted to argue that setting and then meeting a target may have the effect of ‘Goodhart’s Law’. The idea is that once a social or economic measure is turned into a target for policy, it will lose any information content that had qualified it to play such a role in the first place. Essentially, too much faith was put into the idea that if the inflation rate hit 2%, then macroeconomic stability would ensue. Indeed, one could look to other indicators that hinted at the fundamental problems in the British economy. The large current account deficit that Britain experienced during the boom years highlighted the country’s productivity gap to its major trading partners, but this was overlooked (and probably continues to be so). Looking at this in retrospect, it is now easy to reason as productivity growth is the main precursor to long term rises in GDP, that the rise in standard of living until the crisis was based on debt accumulation; unsustainable in the long run. So it would perhaps be fair to say that the inflation target led to unjustified confidence in the economy, and meant that other indicators were given reduced importance, to the detriment of long term sustainable growth.

Furthermore, the target might have also been met as a result of ulterior reasons. In a 2002 paper entitled Does Inflation Really Matter? Manfred Neumann and Jurgen von Hagen argue that the 1990s were in general a stable economic environment, ‘a period friendly to price stability’, as inflation was on a downward trend in many countries (especially developed ones, and even in nations that did not use inflation targeting). Certainly, although inflation targeting contributed to lower inflationary expectations there were more significant causes of the low rate. One main reason would have been the increasing availability of cheap imports from lower wage economies such as China which kept prices artificially low. The high pound coupled with the fact that Britain’s consumers’ marginal propensity to import (which generally tends to rise with income) also helped push the rate down.

Previous comments by Mr Carney hint that this speculation could develop beyond idle dissatisfaction at the current state of affairs. Last December the incoming governor hinted that it might be prudent for Britain to change to a different target designed to help growth if the economy remains stagnant when he takes office in June. One such target which has been suggested is nominal GDP. The idea behind such a change would be to allow the Bank to factor growth more explicitly into its setting of the rate. (Some might argue that at times during the crisis the Bank was essentially targeting nominal GDP).

In an article in The Economist a few years ago discussing this very issue three examples were given as to where a central bank targeting NGDP would have an advantage. The first was during a recession, where output falls but inflation takes longer to readjust. A bank that targets NGDP would be able to accept relatively higher inflation in order to help growth recover. Although of late the Bank of England has followed this principle, by pursuing NGDP it would have more credibility and confidence to do so.

The second situation would be when an economy is struck by a negative supply shock through high oil prices, having the effect of lowering output and raising inflation. If a central bank were to target inflation correctly in this situation then it could risk strangling growth even further, whereas a bank that targets NGDP would be able to be more flexible.

Conversely, during a positive supply shock where a new technology enhances productivity, GDP would rise and inflation would fall. The easing of monetary policy from an inflation targeting central bank that would ensue could lead to asset bubbles.

In a way, this approach may have stood Britain in better stead. As previously alluded, Britain’s inflation rate during the period of inflation targeting was artificially low, so the resulting misplaced confidence in the health of the economy resulted in lower interest rates. This fed into asset bubbles, most notably in housing, and allowed firms and households access to cheap credit, causing private debt to increase. From 2001 up until the crisis, property inflation was at 13% p.a and ‘debt inflation’ at 11.25% on average.

Although nominal GDP has benefits, it does not really offer a solution to the central criticisms levelled at inflation targeting, apart from allowing fresh impetus and outlook stemming from a consideration of more variables. In many ways, the criticisms levelled at inflation targeting are the same that are levelled at the rest of the economy during the ‘boom years’. Misplaced confidence that a temporary illusion was a permanent solution disguised the sickness of the British economy.

On the other hand, it is tempting to think that the Bank of England might be more wary in the future. A change to nominal GDP would simply make the terms set out in the remit more explicit. As of late the Bank has been willing to accept higher inflation, suggesting either that it has been due to cost-push reasons that are largely outwith their control or that it would be foolish to target inflation at a time when growth is so weak. If this attitude could continue, then the positives of inflation targeting – such as the stability the markets crave and the low inflationary expectations – would remain, but the mistakes of the past would to a certain extent be learned. Indeed, adopting a new system might be risky in undermining the confidence that the current system brings. The 2% target might be here to stay for a little while longer yet.